Community property step-up in basis.by Toolson, Richard B.
On the death of a first spouse, community property may be written up to its full fair market value. The author describes community property, how to obtain community-property status, and how to maintain such status when moving to noncommunity-property states.
Currently, there are eight community-property states: Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, and Washington. In 1984, Wisconsin enacted the Marital Property Reform Act, which incorporates many community-property principles and has been recognized by the IRS as a community-property state. Over one-fourth of the population resides in community-property states, several of which are among the fastest growing states in the nation. In our mobile society, this means there are millions of relocations both to and from community- property states. This mobility between states requires that even tax planners in common-law states be aware of the tax implications of owning community property.
Description of Community Property
Federal statutes do not provide a definition of community property. Instead, definitions of community property are provided by the statutory and judicial laws of the community property states. Consequently, there is not a consistent, uniform set of community-property laws. Ultimately, the tax planner needs to examine the statutes and case law of the particular individual community-property state to determine whether property should be classified as community property.
All community-property states define community property by defining what is considered separate property. Community property is considered to be property acquired while domiciled in the state that is not separate property. Separate property is defined as property that is acquired prior to marriage or by gift, bequest, descent, or devise. All property acquired during marriage in a community-property state is presumptively assumed to be community property.
Generally, community property acquired while a couple resides in a community-property state retains its character as community property should the couple move to a common-law state. Moreover, even if the taxpayer is residing in a common-law state, the acquisition of assets traceable to community-property assets will be considered community property assets.
Generally, separate property brought to a community-property state from a common-law state retains its character as separate property. The presumption that all property acquired during marriage in community- property states is community property may be rebuttable when the acquired property is traceable to separate property. That is, if property is acquired during marriage in exchange for separate property or from funds derived from the sale of separate property, the acquired property is considered to be separate property as long as its acquisition can be traced to the separate property. Proof that property is acquired with separate funds, however, must be clear and conclusive in order for the property to retain its separate character.
Income generated from community property is considered community property. Likewise, in most community-property states, income earned from separate property remains separate property. However, three community-property states, Louisiana, Idaho, and Texas, treat income from separate property as community property unless an agreement between the spouses provides that the income from separate property is to remain separate.
Community vs. Separate Property at Death
Under IRC Sec. 1014, the income tax basis of property acquired from a decedent is based on its value for Federal estate tax purposes. As a result, the basis of property held by a decedent is adjusted ("stepped") up or down to its fair market value as of the date of the decedent's death or as of the alternative valuation date pursuant to an election under IRC Sec. 2032.
For property held jointly by a husband and wife, Sec. 2040(b) provides that one-half of the value of the property is included in the estate. Consequently, one-half of the value of the property would be adjusted to its fair market value upon passing to the surviving spouse. In contrast, if property is classified as community property, not only does the decedent's share of property receive a new basis but also the surviving spouse's share receives this same basis if at least one-half of the community property is includable in the decedent's gross estate. Additionally, if the decedent leaves his or her portion of the community property interest to the surviving spouse, there would be no increase in the taxable estate.
Where property has appreciated at the time of the first spouse's death, this step-up of both halves of community property provides potentially significant advantages to the surviving spouse over jointly held property. A higher basis translates to a smaller gain (greater loss) should the spouse sell the property, and if the asset is depreciable, larger depreciation deductions will result. Since assets generally appreciate over time, there will be a tax incentive for most estates to classify assets as community property.
The following examples illustrate the potential advantage that an appreciated asset classified as community property would have over an asset held in joint tenancy when that asset passes to a surviving spouse.
Example 1. Husband and wife own a house with a basis of $20,000 that is considered to be community property. Husband dies leaving his community interest in the house to his spouse. The house is valued at $150,000 for estate tax purposes. The basis in the house is stepped up from $20,000 to $150,000 and one-half of the value of the house would be included in the husband's estate. A marital deduction is allowed for the portion of the house included in the husband's estate since the husband's community interest in the house passes to his wife. The result is no increase in the husband's taxable estate.
Example 2. Assume the same facts as in Example 1 except that the house is held in joint tenancy instead of as community property. The wife's basis in the house would be $85,000, computed as follows: $10,000, which is the wife's one-half share of the original basis of the house, plus $75,000, which is the husband's stepped up basis in his one-half share. Since the surviving spouse will receive full ownership in the house, including one-half the value of the house in the husband's estate would be neutralized by an offsetting marital deduction.
If the property is the separate property (solely owned) of the first spouse to die, there would be a full income tax basis adjustment upon the death of the first spouse. This result is the same as if the property were community property. The following example illustrates this.
Example 3. Wife predeceases her husband. At the time of her death, she owns 100 shares of Primeria Corp. Her basis in the shares at the time of her death was $10,000 and the shares were valued for estate purposes at $50,000. The shares would receive a step-up in basis to $50,000. If the property were community property, the shares would receive the same step-up in basis to $50,000.
On the other hand, if the property is the separate property of the surviving spouse, there would be no income-tax-basis adjustment upon the death of the first spouse.
Example 4. Assume the same facts as Example 3 except that the shares are the separate property of the husband. Since the wife dies before the husband, there would be no step-up in basis. In contrast, if the shares were community property, they would receive a full step-up in basis to $50,000.
Thus, while a full basis adjustment is allowed for community property even though only one-half of the property's value is included in the decedent's gross estate, only the decedent's share of jointly held property is subject to a basis adjustment and there would be no basis adjustment when the property is the separate property of the surviving spouse.
Obtaining Community-Property Status
Because appreciated community property receives a full step-up in basis when either spouse dies, there is a tax advantage in securing community- property status for this property. Of course, if an asset has decreased in value from its adjusted basis at the time of the owner's death, the income tax basis adjustment rules are disadvantageous to community property. For taxpayers domiciled in community-property states, there are two possible ways to convert separate property into community property: 1) deliberately commingling separate property with community property or 2) gifting one-half of a spouse's separate property to the other spouse.
In community-property states, property is presumptively viewed as community unless the property holder is able to prove otherwise. Consequently, intentionally commingling community property with separate property and failing to maintain adequate records so that tracing becomes impossible, will eventually transform separate property into community property. However, intentionally mixing assets to achieve community-property status does create uncertainty whether sufficient commingling has occurred in order to preclude tracing. Nevertheless, it will be necessary to use this method for Texas. In that state, a gift from one spouse to the other will not convert separate property into community property.
No income tax gain or loss is recognized on a transfer of property from one spouse to the other. Moreover, gifts to spouses are excluded in computing taxable gifts. Consequently, a marital agreement between spouses to convert separate or jointly held property to community should not result in adverse tax consequences. Although some states are more flexible than others in allowing spouses to agree among themselves to alter the character of property, converting property by agreement rather than by commingling will normally result in greater assurance that the property's character is community.
To ensure a full step-up in basis, attention should be given to how property is titled. Property intended to be characterized as community property should be titled as community property and not as joint tenants. According to Rev. Rul. 87-98, if property purchased with community funds in a community-property state is titled as joint tenants, it should nevertheless still be possible to obtain a complete basis step-up by expressly stating in joint wills that the property is intended to be a community asset.
Retaining Community-Property Status when Relocating
For a couple residing in a community-property state, there is an opportunity to convert non-community property to community property. In contrast, taxpayers domiciled in common-law states cannot convert noncommunity property to community property. A couple that moves to a common-law state from a community-property state does have the opportunity to retain community-property status for any such transported property. It is important to both maintain good records and to pay careful attention to how property is titled to retain this status.
Generally, in common-law states, how property is titled determines ownership. For example, property held in the name of the husband is considered to be the separate property of the husband and property held in joint tenancy form is considered to be jointly held property. Therefore, to preserve community status, the property should be titled as community property. Moreover, if community property or proceeds from the sale of community property are used to acquire other property, it is essential to maintain complete records to trace the purchase to community property. Rev. Rul. 68-80 presents a scenario in which a couple moves from a community-property state to a common-law state and trades community property owned in the community-property state for real property in the common-law state. They take title to the property in the common-law state as tenants-in-common. The ruling states that under these circumstances no basis step-up would be allowed on the surviving spouse's one-half interest in the property even though community funds were used to purchase it.
Common-law states vary in their recognition of community-property status. When relocating to some common-law states, it may be necessary to adopt strategies other than simply titling assets as community property. One alternative is to leave the community property in the community-property state. Another might be to establish a spousal partnership to hold the community assets. In Rev. Rul. 58-243, the IRS has indicated a willingness to recognize a spousal partnership for Federal income tax purposes even though a husband and wife cannot become partners under state law. The couple might also consider transferring the community property into a revocable intervivos trust to preserve its community-property status. Rev. Rul. 66-283 indicates that community property transferred to such a trust will be treated for income tax basis purposes as community property.
Conversions to Community Property Within One Year of Death
If appreciated property is transformed from separate property to community property and the donee spouse dies within one year of the transformation, then the effect of Sec. 1014(e) on basis step-up needs to be considered. Under Sec. 1014(e), for decedents dying after December 31, 1981, the basis of appreciated property acquired by gift within a one-year period prior to a decedent's death will not be stepped-up to its fair market value if that same property is passed back to the original donor (or donor's spouse). Instead, the basis to the heir-donor will be equal to the decedent-donee's adjusted basis in the property prior to the decedent's death.
Example 5. Husband gifts his entire interest in solely owned property to wife within one year of wife's death. The property passes back to husband upon wife's death. Wife's basis in the property at the time of her death is $50 and its fair market value is $100. Husband's basis in the property would be $50 under Sec. 1014(e).
If separate property is converted to community property by gifting a one-half interest in the property, basis step-up is not as severely affected under Sec. 1014(e). The effect on basis depends on whether the first spouse to die is the one originally owning the property or the one to whom one-half of the separate property is gifted.
If the donor spouse dies first, the property should receive a step-up in basis on both halves of the community property in spite of Sec. 1014(e). The half of the separate property retained by the donor spouse will receive a step-up in basis since it was never gifted to the donee spouse. The half of the separate property gifted to the donee spouse should also receive a step-up in basis since this half was not acquired by the decedent by gift as required under Sec. 1014(e).
Example 6. Husband converts what was previously his solely owned appreciated property to community property by gifting to his wife a one- half share of his separate property. The husband subsequently dies within one year of making the gift, leaving his remaining one-half share in the community property to his wife. Both the half of the property retained by the husband and the half of the property gifted to the wife should be entitled to a step-up in basis.
Suppose instead that the donee spouse dies within one year of being gifted one-half of the property. There still should be a step-up in basis on the half of the property that was not gifted. The Sec. 1014(e) requirement that the property needs to be received by gift from the heir would not apply to the half of the property retained by the donor/heir.
Example 7. Assume the same scenario as in the previous example except that the donee wife dies within one year of being gifted a one-half share of the property. She leaves her share of the community property to her husband. Although no step-up in basis will be permitted on the wife's one-half share, the half of the property retained by the donor- husband would still receive a step-up in basis.
In community-property states, if a spouse with a terminal disease is gifted appreciated separate property from his or her spouse to convert it to community property, then upon the former's death, one-half of the property will receive a step-up in basis. In contrast, if the donor spouse converts appreciated separate property to a joint tenancy form within one year of the death of the donee spouse, neither half of the property would be entitled to a step-up in basis. If the donor spouse dies within one year of transforming separate property to community, there would still be a complete step-up in basis.
Disadvantages in Converting to Community Property
Before converting separate property to community, certain non-tax factors need to be weighed against the advantage of receiving a complete step up in basis. These factors include the donor spouse losing complete management and control of the property and the possible distribution to the donee spouse of an otherwise larger share of the family assets in the event of divorce or the death of the donor spouse.
Under laws adopted by all community-property states, either spouse acting alone, including the donee spouse, may manage and control community property and may dispose of his or her half share of community personality. However, a spouse may not make a gift of community property without the written consent of the other spouse. Moreover, the consent of the other spouse is required before community realty may be sold, conveyed, or encumbered with debt.
In the event of divorce, ownership of property is critical in determining how the property will be divided. In general, community property will be divided in an approximately equal manner among the two spouses.
Separate property that is converted to community may subsequently depreciate in market value. If the property's value declines to the extent that it is worth less at the time of the death of the first spouse, then conversion to community property works to the taxpayer's disadvantage since the basis would be fully stepped down to its fair- market value. Consequently, property that is converted to community will ideally be property whose fair-market value is well in excess of its basis and is not likely to decline significantly in value.
Community-Property Ownership Provides Unique Potential Benefit
The Federal tax system provides a unique benefit to the surviving spouse who holds community property at the date of death of the first spouse. Because of the nature of community-property ownership, the Federal income tax basis of both halves of the property becomes the fair market value at date of death or other optional valuation date. If the community property has appreciated in value, a Federal income tax on that appreciation is avoided. If it is depreciable property, the basis for future depreciation is reset back to fair market value with the potential of increased depreciation deductions against future taxable income.
The potential of significantly lower Federal income taxes by holding community property until the death of one of the spouses is a major planning consideration for those living in or that have lived in community-property states.
Among other things, residents of community-property states will want to explore the possibility of converting separate property to community- property status. Residents of common-law states, through careful planning, will generally be able to preserve the community-property status of property acquired while domiciled in a community-property state. In view of taxpayer mobility between community property and common law states, even tax planners in common-law states should have an elementary understanding of community property laws to properly advise taxpayers who were previously domiciled in community-property states.
Richard B. Toolson, PhD, CPA, is assistant professor of accounting and business law at Washington State University. He is a frequent contributor to tax and accounting journals.
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